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repo workshoprepo, bonds & derivatives
Manila, January 2018
Richard ComottoICMA Centre
University of Reading
United Kingdom
topics
• role of repo
• repo & bonds
• repo & derivatives
structure & operation of the repo market
• securities market liquidity (securities-driven repo)• enhancing settlement efficiency --- covers accidental shorts; equilibrates temporary supply
& demand imbalances; facilitates faster settlement times; prevents market squeezes
• enabling market-making in secondary market --- efficiently finances trading inventory;
covers short positions arising from deliveries without inventory
• financing leveraged investors (including traditional investors) --- supports arbitrage &
boosts market liquidity
• covering short investors --- supports arbitrage; helps prevent asset bubbles
• catalyzing price discovery --- repo rate key to discussing relative value through forward
price; boosts secondary market liquidity; enables arbitrage of anomalies to produce
consistent yield curve ; integrates money & capital markets to produce continuous yield curve
• hedging primary issuance
• supporting corporate bond investors --- allows ‘spreading’ of corporate against
government bonds
• hedging & pricing derivatives
role of repo
• liquidity management (cash-driven repo)• efficient source of liquidity for intermediaries & investors --- mitigation of credit & liquidity
risk produces cheaper funding; diversification of risk attracts lenders & produces deeper
funding; allows temporary liquidation of longer-term assets without disrupting investment
strategy; provides leverage to traditional & alternative investors; funds cross-border
investment in bonds without currency risk
• resilient source of liquidity for both intermediaries & investors --- mitigates liquidity risk
through collateral re-use; reduced liquidity risk encourages term lending & roll-overs; reduced
liquidity risk attracts diversity of lenders, which broadens market; means of temporarily
liquidating longer-term investments with less market impact in crisis
• secure home for short-term investment --- particularly for risk-averse uninsured investors
with no central bank access; flexible tenors
role of repo
• central bank open market operations• secure & efficient market for intervention
• source of benchmarks --- indicators of monetary & macro-prudential conditions; operational
target for monetary policy
• collateral management• collateral transformation --- allows mobilisation, trading & pricing of collateral, including
transformation into cash for CCP variation margins
role of repo
issuers
asset
managers
prime
brokers
repo
dealers
short-term
cash
investors
long-term
investors
primary
dealers
& syndicates
commercial
banks
portfolio
management
portfolio
management
portfolio
management
funding
& liquidity management,
yield enhancement
liquidity management,
yield enhancement
underwriting
risk, liquidity
& funding
management
funding management = borrowing cash liquidity management = lending cash
risk management = covering short hedges or short risk positions yield enhancement = lending out special collateral
market-making = quoting immediately-dealable prices in reasonable amount portfolio management = investment in securities
trading = buying and selling securities for profit underwriting = buying from new issuers at a fixed price in order
primary distribution = selling new securities to investors to sell to investors
primary
distribution
leveraged
investors
trading
trading
trading
& portfolio
management
trading
trading
trading
market-
makers,
other
securities
dealers
systemic cash flowsnon-bank
treasuries,
money
market
investors
primary distribution
© R
DC
om
otto 2
016
cash supply collateral supply
securities
lending&
borrowing
liquidity management
interdealer
repo market cash flows
cash flows only
leveraged financing
commercial
banks
non-bank
financials
(incl. MMMF)
tri-party
agentsbeneficial
owners,
asset
managers
& agents
repo
deskmarket
makers
&
primary
dealers
leveraged
investors &
proprietary
traders
prime
brokers
derivatives
dealers
CCPs
(treasury)
cash
reinvestment
agents
CASHC
OLLA
TE
RA
L
cash
collateral
in securities
lending
central
bank
margin
lending
cash
© RD Comotto 2017
8
• market-making
• hedging new issuance• new issuance
• auctions
• forward markets
• efficient pricing of securities• cost of carry
• forward price/yield
• enhancing securities settlement efficiency
• balancing bond market supply & demand
• collateral transformation
repo & bonds
9
• market-makers are essential to secondary market liquidity
• market-maker provides immediately dealable quotes in
minimum size, whether or not he has a matching customer or
inventory
• by providing immediately dealable quotes, market-makers
create liquidity --- which reduces risk to investors & cost to
issuers
• but providing immediately dealable quotes exposes market-
maker to market & funding liquidity risks --- repo allows
market-maker to hedge intervals between buying & selling
market-making
10
ca
sh
ca
sh
ca
sh
ca
sh
non
-b/m
ark
ben
chm
ark
ben
chm
ark
non-b
/ma
rk
repo
dealer
repo
dealer
market
maker
cash
cash
benchmark security
cash
cash
benchmark security
purchase from customer
eventual sale to another customer
borrowing benchmark bond
to short hedge non-benchmark bond
market-making
non-benchmark security
non-benchmark security
borrowing cash
to fund non-benchmark bond
counter
party 1
purchasepurchase
repurchaserepurchase
investor 1short sale
counter
party 2investor 2purchase to close reverse repo
11
• market-maker may not be able to lay off his customer deal
immediately or may not wish to do so immediately because of
price expectations
• repo of non-benchmark bond purchased from customers
provides funding to market-maker for purchase
• reverse repo of benchmark bond (with similar maturity) allows
market-maker to short hedge market risk
market-making
12
• securities dealers also need repo to hedge primary market
issuance of non-government securities
• principles are same as for market-making
hedging new issuance
13
ca
sh
ca
sh
ca
sh
ca
sh
new
issu
eb
en
chm
ark
ben
chm
ark
new
issu
e
repo
dealer
repo
dealer
market
maker
cash
cash
benchmark security
cash
cash
benchmark security
purchase from issuer
eventual sale to investor
borrowing benchmark bond
to short hedge new issue
new issue
new issue
borrowing cash
to fund new issue
counter
party 1
purchasepurchase
repurchaserepurchase
issuershort sale
counter
party 2investorpurchase to close reverse repo
hedging new issuance
14
• market-makers need repo to offer forward (grey) market to
investors ahead of an auction of government securities
• forward market:• allows investors to reduce risk by fixing price of purchase & ensuring
access to new issue
• spreads supply & demand away from auction day
• provides information to help pricing at auction
hedging new issuance
15
repo
maturity
sell future new bond
to investor
hedge with existing benchmark
bond of similar maturity
maturity
fund long position in benchmark bond with repo to auction:
on auction day, bid for new bond to deliver to investor
& sell off benchmark bond
auction
hedging new issuance
au
cti
on
an
no
un
ce
me
nt
WI/grey/forward market
16
• efficient pricing of bonds depends on an accurate & smooth
yield curve
• an accurate & smooth yield curve depends on the ability of
dealers to buy up cheap bonds & sell off expensive bonds ---
this requires repo
efficient pricing of securities
17
YTM
expensive
cheap
term to maturity
efficient pricing of securities
18
• should we buy the cheap bond?
• should we sell the expensive bond?
• is there real relative value?
efficient pricing of securities
19
• should we buy the cheap bond?
• what is cost of running the long position?
• cost of long position --- pay repo, earn coupon
• if coupon < repo, pay negative carry
• dealers reluctant to take long positions
• is this why bond is cheap?
efficient pricing of securities
20
YTM cheap
term to maturity
if we add in cost of repo funding,
will the value of this ‘cheap’ bond rise & its yield fall
into line with equivalent adjusted value of comparables?
efficient pricing of securities
if it does, then
there is no relative value!
21
• should we sell the expensive bond?
• what is cost of running the short position?
• cost of short position --- earn repo, pay coupon
• if coupon > repo, pay positive carry
• dealers reluctant to take short positions
• is this why bond is expensive?
efficient pricing of securities
22
YTM
expensive
term to maturity
if we add in cost of repo funding,
will the value of this ‘expensive’ bond fall & its yield rise
into line with the equivalent adjusted value of comparables?
efficient pricing of securities
if it does, then
there is no relative value!
23
• build cost of carry into price/yield of bond
• calculate the forward (break-even) price/yield
efficient pricing of securities
24
buy holding period sell
current
clean
priceforward (break-even) price
positive carry
offsetting price fall = carry
profit
loss
efficient pricing of securities
assume no change in clean price
positive carry will generate overall profit
holder can afford to sell at loss = carry
25
buy holding period sell
current
clean
priceforward (break-even) price
positive carry
offsetting price fall = carry
forward price = current clean price - cost of carry
profit
loss
efficient pricing of securities
26
buy EUR25 million nominal 4.5% 04/07/09
price 94.55, yield 5.28956%
83 days accrued interest
fund with repo for 30 days at 4.25%
what is forward price/yield in one month?
efficient pricing of securities
27
buy 25 million nominal 4.5% 04/07/2019
price 94.55, yield 5.28956%
83 days accrued interest (market value = 23,893,322)
fund with repo for 30 days at 4.25%
in 1 month:
accrued interest = 25,000,000 x ------------- = 92,466
repo interest = 23,893,322 x ------------- = 84,622
carry = 92,466 - 84,622 = 7,844
break-even value = 23,637,500 - 7,844 = 23,629,656
forward price = 23,629,656/25,000,000*100 = 94.518626
forward yield = 5.300% (+1bp)
4.5 x 30
100 x 3654.25 x 30
100 x 360
market value
nominal value
value at clean price
efficient pricing of securities
28
0 1 month 3 years
long 3-year bond position at 94.55/5.29%
repo
4.25%forward 211/12-year bond position at 94.52/5.30%
efficient pricing of securities
29
efficient pricing of securities
30
• but cost of carry based on coupon ignores pull-to-par
• pull-to-par means a bond price will converge to par by maturity
• discount bonds will make capital gains --- increasing carry
• premium bonds will make capital losses --- decreasing carry
• pull-to-par capital gains/losses need to be factored into carry
when estimating forward break-even price/yield
• pull-to-par is measured by coupon-YTM differential over
holding period (YTM converges to coupon by maturity)
• to adjust carry & forward break-even price for pull-to-par,
replace coupon with YTM
efficient pricing of securities
carry = YTM – repo rate
carry = 5.28956% (A/A) – 4.25% (A/360)
= 5.28956% (A/A) – 4.309% (A/A) = 0.9805%
31
• market-makers & other securities dealers can fail on onward
deliveries if inward deliveries are late, often because of lack of
supply
• repo market provides temporary supply of securities to borrow
in order to fulfil delivery commitments
• securities markets without parallel repo market suffer from
lower settlement efficiency --- risk to investors increases the
cost of issuance
enhancing securities settlement efficiency
32
• excess demand or supply will cause price to jump --- such
volatility will increase risk to investors & cost of issuance
• if supply cannot meet demand for a bond, dealers will try to
borrow that bond, which will go on special in the repo market
--- offer of cheap cash (yield enhancement) will encourage
more investors to lend the bond
balancing bond market supply & demand
33
• growing demand for collateralisation of financial transactions
& use of central counterparties (CCP)
• growing demand for HQLA
• different counterparties require different types of collateral:
repo allows collateral-providers to exchange collateral in
supply for collateral in demand
• collateral transformation usually involves repoing out asset &
reversing in another --- often called a collateral swap or
collateral upgrade/downgrade trade
collateral transformation
repo
reverse repo
cash
cash
MBS, ABS, etc
government bonds
34
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
hedge funded with repo interest rate swap
Swap dealers typically seek to hedge an IRS position
with an opposite IRS position.
swap
dealer
repo & interest rate swaps
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
35
government
bond yield
ON repo rate
government
bond
repo
But if an opposite IRS was not immediately available,
classic temporary hedge (warehouse) for long IRS position
(paying fixed) was long government bond financed by repo.
repo & interest rate swaps
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1warehouse
36
government
bond yieldgovernment
bond
repo
As soon as an opposite IRS became available,
bond is sold & repo closed out.
repo & interest rate swaps
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1IRS2
ON repo rate
37
swap rate (3.6%) =
government
bond yield (3.0%) +
swap spread (0.6%)
6-mo LIBOR
If swap rate had fallen because of lower government bond yield,
IRS positions would suffer an income loss. However, warehouse
bond would be sold off for offsetting capital gain.
swap
dealer
repo & interest rate swaps
swap rate (3.5%) =
government
bond yield (2.9%) +
swap spread (0.6%)
6-mo LIBOR
38
3.6%
3.0%
0.6%
swap curve
government
bond curve
repo & interest rate swaps
2.9%
3.5%
39
swap rate (3.6%) =
government
bond yield (3.0%) +
swap spread (0.6%)
6-mo LIBOR
But if fall in swap rate was due to narrower swap spread and
government bond yield had not fallen, there would be no capital
gain on warehouse bond to offset income loss on IRS positions.
swap
dealer
repo & interest rate swaps
swap rate (3.5%) =
government
bond yield (3.0%) +
swap spread (0.5%)
6-mo LIBOR
This swap spread risk is problem for hedgers but can be used to
anticipate changes in the swap spread, which is driven by bank
credit & liquidity risk --- swap spread trading
40
3.6%
3.0%0.5%
swap curve
government
bond curve
repo & interest rate swaps
3.5%
41
loss = swap spread
profit = expected LIBOR-repo spread
repo & interest rate swaps
government
bond yieldgovernment
bond
repo
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1IRS2
Classic warehouse provides no-arbitrage pricing model for IRS ---
NPV(swap spread) = NPV(expected LIBOR-repo spread).
No-arbitrage pricing model demonstrates links between
IRS, cash bonds & repo.
ON repo rate
42
loss = swap spread
profit = expected LIBOR-repo spread
repo & interest rate swaps
government
bond yieldgovernment
bond
repo
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1IRS2
What happens to swap rate if government bond goes special?
ON repo rate
43
loss = swap spread
profit = expected LIBOR-repo spread
repo & interest rate swaps
government
bond yield
6-mo repo rate
government
bond
repo
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1IRS2
What happens to swap rate if government bond goes special?
1. repo rate falls below GC.
2. expected profit on floating side increases, ie NPV (expected
LIBOR-repo spread) increases.
3. loss on fixed side has to be increased, ie dealer increases
NPV (swap spread) by increasing swap spread (S)!
44
repo & interest rate swaps
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.020
30
40
50
60
70
80
Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18
Schatz benchmark swap spread (lhs)
RFR German repo rate (rhs)
45
loss = swap spread
profit = expected LIBOR-repo spread
repo & interest rate swaps
government
bond yieldgovernment
bond
repo
swap rate =
government
bond yield +
swap spread
6-mo LIBOR
swap
dealerIRS1IRS2
And happens to swap rate if money market yield curve steepens?
1 6-mo LIBOR rises relative to ON repo rate, so expected
profit on floating side increases, ie NPV (expected LIBOR-
repo spread) increases
2 loss on fixed side has to be increased, ie dealer increases
NPV (swap spread) by increasing swap spread (S)!
ON repo rate
46
repo & interest rate swaps
-0.1
0.0
0.1
0.2
0.3
20
30
40
50
60
70
80
Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18
Schatz benchmark swap spread (lhs)
2nd/ 6th Euribor contract slope (rhs)